Growing geopolitical risk is on everyone’s mind right now, but in today’s Outside the Box, Michael Cembalest of J.P. Morgan Asset Management leads off with a helpful reminder: the only time since WWII that a violent conflict has had a medium-term negative effect on markets was in 1973, when the Israeli-Arab war led to a Saudi oil embargo against the US and a quadrupling of oil prices. And he backs up that assertion with an interesting table of facts labeled “War zone countries as a percentage of total world… [population, oil production, GDP, etc.].”

Having gotten that worry out of the way, he takes on the dire warnings that have recently been issued by the BIS, the IMF, and even the Fed, about a disconnect between market enthusiasm and the undertow of global economic developments. (He gives this section the cute title “Prophet warnings.”) Let’s look, he says, at actual measures of profits and how markets are valuing them; and then he goes on to give us a “glass half-full” take on prospects for the US economy for the remainder of the year. He throws in some caveats and cautions, but Cembalest thinks we could finally see another 3% growth quarter this year, which could create room for further profit increases.

There are good sections here on Europe and emerging markets here, too. Cembalest gives us a true Outside the Box, with a more optimistic view than some of our other recent guests have had. But that’s the point of OTB, is it not, to think about what might be on the other side of the walls of the box we find ourselves in? I have shared his work before and find it well thought out. He is one of the true bright lights in the major investment bank research world. That’s my take, at least.

I write this introduction from the air in “flyover country,” heading back home from rural Minnesota. I flew to Minneapolis to look at a private company that is actually well down the road to creating hearts and livers and kidneys and skin and other parts of the body that can be grown and then put into place. It will not be too many years before that rather sci-fi vision becomes reality, if what I saw is any indication. This group is focused and has what it takes in terms of management and science.

When you hold the beating, pumping scaffolding for a heart in your hand and know that it will soon be a true heart – albeit for a test animal at this point, though human trials are not that far off – then you can well and truly feel that we are entering a new era. I declined to pick up a rather huge liver, but the chief scientist handled it like it was just another auto part. Match these “parts” with young IPS cells, and we truly will have replacement organs ready for us when we need them, if we can wait another decade or so (or maybe half that time for some organs!). My friend and editor of Transformational Technology Alert, Patrick Cox, toured the place with me and will write about it in a few weeks. (You will be able to see his complete analysis of this company for free in his monthly letter on new technologies. You can subscribe here.)

Ukraine and Gaza are epic tragedies, but gods, what wonders we humans can create when we pursue life rather than death. It just makes you want to take some people by the back of the neck and shake some sense into them.

And now a brief but enlightening tale from … The Road. It’s about the Code of the Road Warrior. The Road can be a lonely place, soul-searing in its weariness, with only brief moments of pleasure. But you have to do it because that is what the job requires. And there are lots of us out there. You see the look, you recognize yourself in the other person. If you can help, you do. It’s the unwritten Code that we all come to realize you must live by. It has nothing to do with race, religion, sexual alignment, or political persuasion. You help fellow Road Warriors on the journey.

As do we all, you seek out your favorite airline club in airports (for me it’s the American Airlines Admirals Club) and know you are “home.” A comfortable chair for your back, a plug for your tools, a drink to quench your thirst, and peace for your soul. But then there are the times when you are in an airport where there is no home for you.

Over the years, I have invited dozens of fellow Road Warriors to be my “guest” in a club. No true cost to me, just a courtesy you give a fellow Roadie. Today, I arrived at the Minneapolis airport, and there Delta and United rule. My companion, Pat Cox, was traveling on Delta back to Florida, so I thought I would see if my platinum card would get us into the Delta lounge. Turns out it would, but only if I was on Delta. I was getting ready to limp away to seek some other place of solace for a few hours when a fellow Road Warrior behind me said, “He is my guest.”

The lady behind the counter said, “That’s fine, but you can only have one guest.” Then the next gentleman looked at Pat in his Hawaiian shirt and flip-flops and said, “He is my guest.” The lady at the counter smiled, knowing she was faced with the Code of the Road Warrior, and let us in.

You have to understand that Pat is nowhere close to being a Road Warrior. He agrees with cyberpunk sci-fi author William Gibson that “Travel is a meat thing.” He indulged me for this trip. I will admit to being meat. I like to meet meat face to face when I can.

So Pat was somewhat puzzled, and he turned to our two benefactors and asked, “Do you know him?” (referring to me). Pat assumed they had recognized me, which sometimes does happen in odd places. But no, they had no idea. I told him I would explain the Code of the Road Warrior to him when we sat down, and everyone grinned at Pat’s astonishment over a random act of kindness. So we said thank you to our Warrior friends, whom we will likely never meet again, and entered into the inner sanctum. With electrical outlets.

The Road can be lonely, but many of us share that space. If you are one of us, then make sure you obey the Code. Someday, it will bring help to you, too. And as I write this, my AA travel companion on the flight back, an exec who runs a large insurance company, who was trying to figure out what the heck today’s court ruling might do to the 70,000 subsidized policies they sold, noticed I did not have the right connection and dug through his bag and found the right plug for me. It’s a Code thing. I knew him only as Ken, and he knew me as John. We then both hunched over our computers and worked.

Have a great week. And maybe commit a random act of kindness, even if you are not on The Road.

Each day, you get the three tech news storieswith the biggest potential impact.

Geopolitics and markets; red flags raised by the Fed and the BIS on risk-taking

Michael Cembalest, J.P. Morgan Asset Management

Eye on the Market, July 21, 2014

You can be forgiven for thinking that the world is a pretty terrible place right now: the downing of a Malaysian jetliner in eastern Ukraine and escalating sanctions against Russia, the Israeli invasion of Gaza, renewed fighting in Libya, civil wars in Syria, Afghanistan, Iraq and Somalia, Islamist insurgencies in Nigeria and Mali, ongoing post-election chaos in Kenya, violent conflicts in Pakistan, Sudan and Yemen, assorted mayhem in central Africa, and the situation in North Korea, described in a 2014 United Nations Human Rights report as having no parallel in the contemporary world. Only in Colombia does it look like a multi- decade conflict is finally staggering to its end. For investors, strange as it might seem, such conflicts are not affecting the world’s largest equity markets very much. Perhaps this reflects the small footprint of war zone countries within the global capital markets and global economy, other than through oil production.

The limited market impact of geopolitics is nothing new. This is a broad generalization, but since 1950, with the exception of the Israeli-Arab war of 1973 (which led to a Saudi oil embargo against the US and a quadrupling of oil prices), military confrontations did not have a lasting medium-term impact on US equity markets. In the charts below, we look at US equities before and after the inception of each conflict in three different eras since 1950. The business cycle has been an overwhelmingly more important factor for investors to follow than war, which is why we spend so much more time on the former (and which is covered in the latter half of this note).

As for the war-zone countries of today, one can only pray that things will eventually improve. Seventy years ago as the invasion of Normandy began, Europe was mired in the most lethal war in human history; the notion of a better day arising out of misery is not outside the realm of possibility.

Soviet invasions of Hungary and Czechoslovakia did not lead to a severe market reaction, nor did the outbreak of the Korean War or the Arab-Israeli Six-Day War.

We did not include the US-Vietnam war, since it’s hard to pinpoint when it began. One could argue that Vietnam-era deficit spending eventually led to rising inflation (from 3% in 1967 to 5% in 1970), a rise in the Fed Funds rate from 5% in 1968 to 9% in 1969, and a US equity market decline in 1969-1970 (this decline shows up at the tail end of the S&P series showing the impact of the Soviet invasion of Czechoslovakia).

The Arab-Israeli war of 1973 led to an oil embargo and an energy crisis in the US, all of which contributed to inflation, a severe recession and a sharp equity market decline. Pre-existing wage and price controls made the situation worse, but the war/embargo played a large role. Separately, markets were not adversely affected by the Falklands War, martial law in Poland, the Soviet war in Afghanistan, or US invasions of Grenada or Panama. The market decline in 1981 was more closely related to a double-dip US recession and the anti-inflation policies of the Volcker Fed.

Equity market reactions to US invasions of Kuwait and Iraq, and the Serbian invasion of Kosovo, were mild. There was a sharp market decline after the September 11th attacks, but it reversed within weeks. The subsequent market decline in 2002 was arguably more about the continued unraveling of the technology bust than about aftershocks from the Sept 11thattacks and Afghan War. As for North Korea, in a Nov 2010 EoTM we outlined how after North Korean missile launches, naval clashes and nuclear tests, South Korean equities typically recover within a few weeks.

Prophet warnings. So far, the year is turning out more or less as we expected in January: almost everything has risen in single digits (US, European and Emerging Markets stocks, fixed-rate and inflation linked government bonds, high grade and high yield corporate bonds, and commodities). What made last week notable: concerns from the Fed and the Bank for International Settlements (a global central banking organization) regarding market valuations. The BIS hit investors with a 2-by-4, stating that “it is hard to avoid the sense of a puzzling disconnect between the market’s buoyancy and underlying economic developments globally”. The Fed also weighed in, referring to “substantially stretched valuations” of biotech and internet stocks in its Monetary Policy Report submitted to Congress. What should one make of these prophet warnings?

Let’s put aside the irony of Central Banks expressing concern about whether their policies are contributing to aggressive risk-taking. They know they do, and relied on such an outcome when crafting monetary policy post-2008. Instead, let’s look at measures of profits and how markets are valuing them. The first chart shows how P/E multiples have risen in recent months, including in the Emerging Markets. The second chart shows valuations on internet and biotech stocks referred to in the Fed’s Congressional submission. The third chart shows forward and median multiples, an important complement to traditional market-cap based multiples.

Are these valuations too high? Triangulating the various measures, US valuations are close to their peaks of prior mid-cycle periods (ignoring the collective lapse of judgment during the dot-com era). We see the same general pattern in small cap. On internet and biotech, valuations have begun to creep up again after February’s correction, and I would agree that investors are paying a LOT of money for the presumption that internet/biotech revenue growth is “secular” and less explicitly linked to overall economic growth.

As a result, we believe earnings growth is needed to drive equity markets higher from here. On this point, we see the glass half-full, at least in the US. After a poor Q1 and a partial rebound in Q2, US data are improving such that we expect to see the elusive 3% growth quarter this year (only 6 of 20 quarters since Q2 2009 have exceeded 3%). With new orders rising and inventories down, the stage is set for an improvement. Other confirming data: vehicle sales, broad-based employment gains, hours worked, manufacturing surveys, homebuilder surveys, a rise in consumer credit, capital spending, etc. If we get a growth rebound, the profits impact could be meaningful. The second chart shows base and incremental profit margins. Incremental margins measure the degree to which additional top-line sales contribute to profits. After mediocre profits growth of 5%-7% in 2012/2013, we could see faster profits growth later this year. With 83 compan ies reporting so far, Q2 S&P 500 earnings are up 9% vs. 2013.

Accelerated monetary tightening could derail interest-rate sensitive sectors of the economy, so we’re watching the Fed along with everybody else. Perhaps it’s a reflection of today's circumstances, but like Bernanke before her, Yellen appears to see the late 1930s as a huge policy fiasco: when premature monetary and fiscal tightening threw the US back into recession. That’s what Yellen's testimony last week brings to mind: she gave a cautious outlook, cited "mixed signals" and previous "false dawns", and downplayed the decline in unemployment and recent rise in inflation. In other words, she’s prepared to wait until the US expansion is indisputably in place before tightening.

An important sub-plot for the Fed: where are all the discouraged workers? For Fed policy to remain easy, as the economy improves, the pace of unemployment declines will have to slow and wage inflation will have to remain in check. The Fed believes discouraged workers will re-enter the labor force in large numbers, holding down wage inflation. Fed skeptics point out that so far, labor participation rates have not risen, creating the risk of inflation sooner than the Fed thinks. It’s all about the “others” in the chart, since disabled and retired persons rarely return to work. If “others” come back, it would show that there hasn’t been a structural decline in the pool of available workers. The Fed believes they will eventually return, and so do we.

Europe

Germany and France are slowing; not catastrophically, but by more than markets were expecting. This has contributed to a decline in European earnings expectations for the year. As shown on page 2, Europe was priced for a return to normalcy, and with inflation across most of the Eurozone converging to 1%, things are decidedly not that normal. Markets are not priced for any negative surprises, which is why an issue with a single Portuguese bank contributed to a sharp decline in banks stocks across the entire region.

Emerging Markets

The surprise of the year, if there is one, is how emerging markets equities have rebounded. As we wrote in March 2014, the history of EM equities shows that after substantial currency declines, industrial activity often stabilizes. Around that same time, we often see equity markets stabilize as well, even before visible improvements in growth, inflation and exports. This pattern appears to be playing itself again: the 4 EM Big Debtor countries (Brazil, India, Indonesia and Turkey) have experienced equity market rallies of 20%+ despite modest improvement in economic data (actually, things are still getting worse in Brazil and Turkey).

There’s also some good news on the EM policy front. In Mexico, it appears that the oil and natural gas sector is being opened up after a 25% decline in oil production since 2004. This would effectively end the 75-year monopoly that Pemex has over oil production. Other energy–related positives: Mexico has shifted the bulk of its electricity reliance from oil to cheaper natural gas over the last decade, giving it low electricity costs along with its competitive labor costs. Factoring in new energy investment, new telecommunications and media projects opened to foreign investment and support from both private and public credit, we can envision a 2% boost to Mexico’s GDP growth rate in the years ahead. This can not come soon enough for Mexico: casualties in its drug war rival some of the war zone countries on page 1.

Now for the challenges. Brazil has bigger problems right now than its mauling at the World Cup. With goods exports, manufacturing and industrial confidence slowing and wage/price inflation rising, Brazil is about to experience a modest bout of stagflation. Markets don’t appear to care (yet).

As for China, growth has stabilized (7%-8% in Q2) but we should be under no illusion as to why: credit growth is rising again. China ranks at the top of list of countries in terms of corporate debt/GDP. I don’t know what the breaking point is, but we’re a long way from pre-crisis China when GDP growth was organically driven and less reliant on expansion of household and corporate debt1. There’s some good news regarding the composition of growth: investment is slowing in manufacturing and real estate, and increasing in infrastructure; and while capital goods imports are flat, consumer goods imports are rising, suggesting a modest transition to more consumer-led growth. But for investors, the debt overhang of state-owned enterprises and its impact on the economy is the dominant story to watch. That explains why Chinese equity valuations are among the lowest of EM countries (only Russia is lower; for more on its re- militarization, economy and natural gas relations with Europe, see “Eye on the Russians”, April 29, 2014).

On a global basis, demand and inventory trends suggest a pick-up in economic activity in the second half of the year. If so, our high single digit forecast for 2014 equity market returns should be able to withstand the onset of (eventually) tighter monetary policy in the US. The ongoing M&A boom probably won’t hurt either.

ECONOMY & MARKETS | 07.24.2014

What Comes After the Next Crash...And Why You Should Care

Dear Subscriber,Between now and 2019 we face the perfect storm.At the same time, the next technology revolution is brewing, and we can expect to see booming results from 2023 to 2036. (Not as great a boom as we've seen from 1983 to 2007, but still worth watching for.)And I know all of this thanks to the cycles I’ve identified over the years, and which I use to forecast booms and busts years — even decades — ahead.At present, these cycles are clearly pointing to the next great crash... but right behind that is the next concerted boom.Now, I’m willing to bet money that you’ve been taught to believe that forecasting long-term is nearly impossible. Well, I’m here to tell you…What B.S.!

Predicting longer term trends is a piece of cake!It’s the short-term that's more difficult, especially when governments try to keep the economy and markets alive with endless stimulus and manipulation.What makes long-term forecasting so easy is my three key “Macro Cycles.” When they are all negative together, as they are now, you can expect things to be rough. But when they're all positive together, you have a near-guaranteed boom.The last time the three longer term cycles were full-out bullish was between 1988 and 2000. The boom/bust cycle was bullish from 1996 into 2000 when we had the great tech bubble and is now bearish from mid-2014 into early 2020. The next larger bullish cycle is between 2020 and 2036.So what are these three macro cycles? They are…

Let’s look at Innovation Cycles first…The last mainstream technology revolution converged around the Internet as it accelerated from 10% to 90% of households in the U.S. between 1993/1994 and 2008/2010.The chart below shows how major technology S-Curves overlap with the Internet revolution now maturing AND the nanotechnology revolution emerging (which includes biotech, robotics and alternative energy). You’ll see that they’re set to surge between around 2022/2023 and 2036/2037.

The simple logic here is that the last revolution matures after 90% penetration, while the next one is emerging into niche markets, from 0.1% to 10%. Then that next revolution accelerates mainstream. This occurs about every 45 years. Steamships peaked around 1875, then railroads around 1920, then autos around 1965 and now the Internet and wireless communications around 2010.And each major S-Curve acceleration from 10% to 90% lasts 14 to 15 years… then the overlap period follows for another 14 to 15 years.So expect to see this begin to take place in the early 2020s or so, before swinging into full gear and roaring to the moon again. But the next major peak in innovation will have its greatest impact into around 2055.As far as my most critical economic cycle — the Spending Wave — is concerned, wherein new generations enter the workforce in increasing numbers and earn and spend more money until their kids leave the nest:Today people reach their peak spending point around age 46. When we lag the U.S. birth index by 46 years, it’s possible to see when spending will increase and when it will taper off.That’s how we predicted a boom from 1983 through 2007.That’s how we forecast the downturn from 2008 into 2020/2022.And that’s how we know when the next boom will take place. You see, this cycle turns up again from 2023 into 2036 as the echo boomer generation moves through its first predictable spending wave. Then there will be a second phase of that generation’s boom from around 2044/2045 into 2055 — right in line with the next longer term innovation cycle.Then there’s my third macro cycle: The Geopolitical Cycle that shifts from positive to negative every 17 to 18 years.1983 to 2000 was the last positive cycle. That turned negative in 2001 and we're witnessing the effects all around us, starting with 9/11, with civil war threatening in the Middle East and passenger planes being shot out of the sky in Ukraine.Unfortunately, this negative side of the cycle should last into around late 2019 or early 2020, at which point it will flip to the positive again until about 2036 or 2037. When it does, I hope you're ready for the next concerted global boom.In short, all three macro cycles will switch into boom mode at the same time between 2023 and 2036! All three point down together from late 2007 into late 2019 or early 2020.The perfect storm turns back into sunny skies again.So on those days when it feels like the end of America has come, remember that, in fact, the opposite is true. We've got some great years ahead of us, once we've moved through this economic winter season.Start preparing now for the next wealth-building boom. But first prepare for the worst economic season of your lifetime from late 2014 into early 2020.

HarryP.S. I'm not the only one who relies heavily on cycles to better understand the economy and markets and — most importantly — to take advantage of what's happening. Adam, our chief investment strategist is the same. That's how he's been able to show his Cycle 9 Alert subscribers how to make $22,760 in just 27 days. More than that, he's shown them how to repeat such winnings over and over again. To discover what cycles he follows, click here.

Greenspan says bubbles can’t be stopped without ‘crunch’

Former Fed chairman worries about false dawns and the looming Fed exit

Getty Images
Former Federal Reserve Chairman Alan Greenspan speaks before the Economic Club of New York on April 28.

WASHINGTON (MarketWatch) — Former Federal Reserve Chairman Alan Greenspan has always been a student of the economy. Since the financial crisis, he’s become a student of human nature.

Sitting in his office with a view of the Washington Monument in the distance, Greenspan is eager to share the insight distilled in his recent book, “The Map and the Territory,” due out in paperback this fall.

‘There is definite evidence the economy is picking up. The financial system is finally beginning to lend. But, what we don’t know is whether, when the recovery gets underway, it is going to run into another false dawn.’

Alan Greenspan to MarketWatch

Greenspan, 88, who was chairman of the U.S. central bank for more than 18 years, from 1987 to 2006, managed to steer the economy through multiple crises, mainly by slashing rates and remaining upbeat. He suffered a remarkable fall from grace after leaving office and has apologized for trusting big banks too much. He has since gone back and re-examined his views on the economy.

Greenspan, now the president of Greenspan Associates LLC, an economic consulting firm, spoke to MarketWatch about the current stance of Fed policy, the economy and what to do about asset bubbles. The economy will do all right in the near term, he said, buoyed by a strong equity market, but he added that he remains worried that we could be facing another false dawn.

The interview has been edited for length and clarity.

MarketWatch: What is the biggest challenge facing the Fed?

Greenspan: How to unwind the huge increase in the size of its balance sheet with minimal impact. It is not going to be easy, and it is not obvious exactly how to do it.

MarketWatch: As the Fed is looking at the exit, do you think we can get through this without upsetting the economy?

Greenspan: I certainly hope so. I certainly think they will. But it is going to be difficult.

MarketWatch: Do you expect a sharp market reaction to the first hike?

Greenspan: Of course. Look what happened when the first indication of tapering occurred. Markets have always been sensitive. They reflect animal spirits.

MarketWatch: Will the Fed’s communication to markets be key here?

Greenspan: I am not sure. One area I was always doubtful about during my tenure is how much we could effectively communicate to markets, because they were always second guessing the Fed. It was a battle, and I am not sure we always won.

MarketWatch: The Fed has been talking recently about stock-market valuations — do you think that’s wise?

Greenspan: You can’t get around the fact that asset values have a major impact on economic activity, and no central bank can be oblivious to what is happening, not only in credit markets, which is, of course, the Fed’s fundamental mandate, but in asset markets, as well. As a central banker, in addition to evaluating stock prices, you have to cover commercial-real-estate markets, commodity markets and the price of owner-occupied homes, as well. Without asset-market surveillance, you do not have an integrated view of how the economy works. How to respond to asset-price change is a legitimate issue. But not to monitor it, I think, is clearly a mistake.

MarketWatch: What was your reaction to Fed Chairwoman Yellen’s speech at the IMF, where she said the central bank would use regulation first if there were concerns about asset prices?

Greenspan: There is a fundamental distinction. I happen to agree that bubbles are primarily an issue to be addressed by regulation.

The Fed tried in 1994 to defuse a bubble with monetary policy alone. We called it a boom back then. The terminology has changed, but the phenomenon is the same. We increased the federal funds rate by 300 basis points, and we did indeed stop the nascent stock-market bubble expansion in its tracks. But after we stopped patting ourselves on the back for creating a successful soft landing, it became clear that we hadn’t snuffed the bubble out at all. I have always assumed that the ability of the economy to withstand the 300-basis-point tightening revised the market’s view of the sustainability of the boom and increased the equilibrium level of the Dow Jones Industrial Average. The dot-com boom resumed.

When bubbles emerge, they take on a life of their own. It is very difficult to stop them, short of a debilitating crunch in the marketplace. The Volcker Fed confronted and defused the huge inflation surge of 1979 but had to confront a sharp economic contraction. Short of that, bubbles have to run their course. Bubbles are functions of unchangeable human nature. The obvious question is how to manage them.

All bubbles expand, and they all collapse. But how they are financed is critical. The dot-com boom [of 1994 to 2000] produced a huge financial collapse with almost no evidence of economic impact. You will be hard pressed to see it in the GDP figures of the early 2000s. Similarly, on Oct. 19, 1987, the Dow Jones Industrial Average fell 23% — an all-time one-day record, then and since. Goldman was contemplating withholding a $700 million payment to Continental Illinois Bank in Chicago scheduled for the Wednesday morning following the crash. In retrospect, had they withheld that payment, the crisis would have been far more disabling. Few remember that crisis because nothing happened as a consequence. But it was the scariest experience I had during my 18 years at the Fed.

In both cases, equity values collapsed, with wrenching losses to the holders of stock, primarily pension and mutual funds and households, none of which were sufficiently debt-leveraged to induce contagious defaults.

It turns out the reason why the more recent housing bubble was so dramatically different was that its toxic assets, subprime mortgages, were out there exposed with very little equity buffer. In a collapse in stock prices with no debt, unleveraged holders get the full impact of the equity loss, but there is no serial contagion. That was not the case in the housing bubble or the highly leveraged stock market of 1929.

So it is not the toxic assets — stocks or subprime mortgages — that matter, but the degree of leverage taken on by the institution that is handling it. Contingent convertible debentures can importantly reduce the risk of serial debt contagion. The debenture debt can be converted to new equity as the overall equity buffer shrinks.

MarketWatch: Some economists argue that the economy has just been bubble after bubble and that we’re doomed to repeat this cycle.

Greenspan: Well, I agree with that. I have come to the conclusion that bubbles, as I noted, are a function of human nature. We don’t have enough observations, but my tentative hypothesis to what we’re dealing with is that both a necessary and sufficient condition for the emergence of a bubble is a protracted period of stable economic activity at low inflation. So it is a very difficult policy problem. I do believe that central banks that believe they can quell bubbles are living in a state of unrealism.

MarketWatch: Well, the comments I read from economists reflect concern that bubbles are a sign there are not enough productive investments, like factories, in the economy.

Greenspan: That’s a legitimate concern. The question is why. If you trace the history of the average maturity of the components of GDP, what you find is that all of the shortfall of economic activity following 2008 is in very long-lived assets, fundamentally structures. Every single one of the 10 major postwar recoveries was heavily driven by a faster-than-GDP growth in structures — except this one. What went wrong? Business and household fear gripped the markets in ways not seen since before World War II. The share of nonfinancial corporate liquid cash flow that corporate management chooses to invest in illiquid long-term assets fell to the lowest peacetime level since 1938. Householders engaged in a massive shift from long-term homeownership to rentals.

Fear has diminished somewhat, but the shortfall in GDP from its potential is still predominately in these very long-lived assets that are discounted heavily. There is definite evidence the economy is picking up. The financial system is finally beginning to lend. But, what we don’t know is whether, when the recovery gets underway, it is going to run into another false dawn.

Gross domestic savings and capital investment as a share of GDP have declined significantly in recent years. It is the cause of the slowdown in productivity growth and standards of living. At root, the problem is government deficits suppressing the national savings rate. Until we come to grips with that, it is going to be difficult to get the economy moving in a sustainable way.